Proximate Versus Fundamental Causes

“...the factors we have listed (innovation, economies of scale, education, capital accumulation etc.) are not causes of growth; they are growth." (North and Thomas, 1973, p.

The previous chapter illustrated how the Solow growth model can be used to understand cross-country income differences and the process of economic growth. In the context of the Solow growth model, the process of economic growth is driven by technological progress. Cross-country income differences, on the other hand, are due to a combination of technol­ogy differences, differences in physical capital per worker and in human capital per worker. While this approach provides us with a good starting point and delineates potential sources of economic growth and cross-country income differences, these sources are only proximate causes of economic growth and economic success. Let us focus on cross-country income dif­ferences, for example. As soon as we attempt to explain these differences with technology, physical capital and human capital differences, an obvious next question presents itself: if technology, physical capital and human capital are so important in understanding differences in the wealth of nations and if they can account for five-fold, ten-fold, twenty-fold or even thirty-fold differences in income per capita across countries, then why is it that societies do not improve their technologies, invest more in physical capital and accumulate more human capital?

It appears therefore that any explanation that simply relies on technology, physical capital and human capital differences across countries is, at some level, incomplete. There must be some other reasons underneath those, reasons which we will refer to as fundamental causes of economic growth. It is these reasons that are preventing many countries from investing enough in technology, physical capital and human capital.

An investigation of fundamental causes of economic growth is important for at least two reasons. First, any theory that focuses on the intervening variables (proximate causes) alone, without understanding what the underlying driving forces are, would be incomplete. Thus growth theory will not fulfill its full promise until it comes to grips with these fundamen­tal causes. Second, if part of our study of economic growth is motivated by improving the growth performance of certain nations and the living standards of their citizens, understand­ing fundamental causes is central to this objective, since attempting to increase growth just focusing on proximate causes would be tantamount to dealing with symptoms of diseases without understanding what the diseases themselves are. While such attacks on symptoms can sometimes be useful, they are no substitute for a fuller understanding of the causes of the disease, which may allow a more satisfactory treatment. In the same way, we may hope that an understanding of the fundamental causes of economic growth could one day offer more satisfactory solutions to the major questions of social science concerning why some countries are poor and some are rich and how we can ensure that more nations grow faster.

What could these fundamental causes be? Can we make progress in understanding them? And, perhaps most relevant for this book, is growth theory useful in such an endeavor?

In this chapter, I attempted develop some answers to these questions. Let us start with the last two questions. The argument in this book is that a good understanding of the mechanics of economic growth, thus the detailed models of the growth process, are essential for a successful investigation of the fundamental causes of economic growth. This is for at least two reasons; first, we can only pose useful questions about the fundamental causes of economic growth by understanding what the major proximate causes are and how they impact economic outcomes. Second, only models that provide a good approximation to reality and are successful in qualitatively and quantitatively matching the major features of the growth process can inform us about whether the potential fundamental causes that are proposed could indeed play a significant role in generating the huge income per capita differences across countries.

Returning to the first question, there are innumerable fundamental causes of economic growth that various economists, historians and social scientists have proposed over the ages. Clearly, listing them and cataloging them will be neither informative nor useful. Instead, I will classify the major candidate fundamental causes of economic growth into four categories of hypotheses. While such a classification undoubtedly fails to do justice to some of the nuances of the previous literature, it is satisfactory for our purposes of bringing out the main factors affecting cross-country income differences and economic growth. These are:

(1) The luck hypothesis.

(2) The geography hypothesis.

(3) The culture hypothesis.

(4) The institutions hypothesis.

By luck, I refer to the set of fundamental causes that explain divergent paths of economic performance among otherwise-identical countries, either because some small uncertainty or heterogeneity between them have led to different choices with far-ranging consequences, or because of different selection among multiple equilibria. Multiple equilibria correspondent to different equilibrium configurations arising for the same underlying economic environment. When our models exhibit multiple equilibria, we are often unable to make specific predictions as to which of these equilibria will be selected by different countries and it is possible for two otherwise-identical countries to end up in different equilibria with quite different implications for economic growth and living standards. Luck and multiple equilibria can manifest them­selves through any of the proximate causes discussed so far (and through some additional mechanisms that will be discussed later in the book).

By geography, I refer to all factors that are imposed on individuals as part of the physical, geographic and ecological environment in which they live. Geography can affect economic growth through a variety of proximate causes. Geographic factors that can influence the growth process include soil quality, which can affect agricultural productivity; natural re­sources, which directly contribute to the wealth of a nation and may facilitate industrial­ization by providing certain key resources, such as coal and iron ore during critical times; climate, which may affect productivity and attitudes directly; topography, which can affect the costs of transportation and communication; and disease environment, which can affect individual health, productivity and incentives to accumulate physical and human capital. For example, in terms of the aggregate production function of the Solow model, poor soil quality, lack of natural resources or an inhospitable climate may correspond to a low level of A, that is, to a type of “inefficient technology”. Many philosophers and social scientists have suggested that climate also affects preferences in a fundamental way, so perhaps individuals living in certain climates have a preference for earlier rather than later consumption, thus reducing their saving rates both in physical and human capital. Finally, differences in the disease burden across areas may affect the productivity of individuals and their willingness to accumulate human capital. Thus geography-based explanations can easily be incorporated into both the simple Solow model as well as into many of the more sophisticated models discussed later in the book.

By culture, I refer to beliefs, values and preferences that influence individual economic behavior.

By institutions, I refer to rules, regulations, laws and policies that affect economic incen­tives and thus the incentives to invest in technology, physical capital and human capital. It is a truism of economic analysis that individuals will only take actions that are rewarded. Insti­tutions, which shape these rewards, must therefore be important in affecting all three of the proximate causes of economic growth. What distinguishes institutions from geography, luck and culture is that they are social choices. While laws and regulations are not directly chosen by individuals and some institutional arrangements may be historically persistent, in the end the laws, policies and regulations under which a society lives are the choices of the members of that society. If the members of the society collectively decide to change them, they can change them. This implies that if institutions are a major fundamental cause of economic growth and cross-country differences in economic performance, they can be potentially re­formed so as to achieve better outcomes.

There is a clear connection between institutions and culture. Both affect individual behavior and both are important determinants of incentives. Nevertheless, a crucial difference between the theories put into these two categories justifies their separation. Institutions are directly under the control of the members of the society, in the sense that by changing the distribution of resources, constitutions, laws and policies, individuals can collectively influence the institutions under which they live. In contrast, culture refers to a set of beliefs that have evolved over time and outside the direct control of individuals.^[IV] Even though institutions might be hard to change in practice, culture is much harder to influence, and any advice to a society that it should change its culture is almost vacuous.

It is also important to emphasize that institutions themselves, even if they are a funda­mental cause of economic growth and income differences across countries, are endogenous. They are equilibrium choices made either by the society at large or by some powerful groups in society. One can then argue that at some level luck, geography or culture should be more important, because they can be “more exogenous” in the sense that they are not equilibrium choices in the same way as institutions are and institutions will vary across societies largely because of geographic, cultural or random factors. While at some philosophical level this is correct, it is not a particularly useful observation. It neither obviates the need to understand the direct effects of luck, geography, culture and institutions (these direct effects have been the focus of much of the debate in this area) nor does it imply that understanding the spe­cific role of institutions and economic development is secondary in any sense. After all, if we can understand what the effects of institutions are and which specific types of institutions matter, institutional reform can lead to major changes in economic behavior (even if part of the original variation in institutions was due to geography, luck or culture).

In the rest of this chapter, I will explain what the reasoning for these different hypotheses are and provide a brief overview of the empirical evidence pertaining to various fundamental causes of economic growth. The theoretical underpinnings and implications of the institutions view will be further developed in Part 8 of the book. At this point, the reader should be warned that the author of this book is not an objective outside observer in this debate, but a strong proponent of the institutions hypothesis. Therefore, not surprisingly, this chapter will conclude that the institutional differences are at the root of the important proximate causes that we have already listed. Nevertheless, the same evidence can be interpreted in different ways and the reader should feel free to draw his or her own conclusions.

Before delving into a discussion of the fundamental causes, one other topic deserves a brief discussion. This is where I start in the next section.

4.2.